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Research Highlights 2010: Macroeconomics and Growth

Growth is essential for lasting poverty reduction. Designing policies and reform strategies conducive to sustained high growth requires a better understanding of the diversity of aggregate economic performance across the world, and how it responds to policy and institutional changes under different country circumstances.

Themes

Research on the roots of sustained growth investigates how micro- and macroeconomic policy actions and reforms translate into lasting growth, with attention to the role of country-specific initial conditions and policy complementarities.

Work on the global financial crisis examines its propagation mechanisms and assesses policy responses—especially fiscal—to mitigate the adverse consequences for growth. Research seeks to draw lessons for the management of macroeconomic risks posed by deepening international economic integration.

Research on governance and political economy examines the consequences of weak governance for government performance, macroeconomic stability and growth, and identifies institutional reforms and incentives that contribute to improve governance.[1]

Highlights

Foreign reserve accumulation to support export-led growth—does it make sense?

Some fast-growing emerging countries have amassed vast amounts of foreign assets as part of a so-called “neo-mercantilist” growth strategy, based on the promotion of exports through undervaluation of the real exchange rate. Such a strategy may improve welfare in economies whose tradable sector generates learning-by-investing externalities.

If the government cannot target incentives accurately, or if its policy choices are restricted by multilateral agreements, first-best policies such as subsidies to capital accumulation or to tradable goods production are not feasible. But a policy of foreign reserve accumulation can achieve the same ends by providing loans to foreigners to buy domestic tradable goods. This raises the relative price of tradable versus non-tradable goods (and thus undervalues the real exchange rate) at the cost of temporarily reducing tradable absorption in the domestic economy. However, since the tradable sector generates greater learning-by-investing externalities, such policy also leads to dynamic gains in the form of higher growth. The net welfare effects depend on the balance between the static losses from lower tradable absorption versus the dynamic gains from higher growth. The conditions under which this kind of reserve hoarding is welfare-improving are the same as those under which foreign aid inflows are welfare-reducing.[2]

The “war on drugs” needs to be re-evaluated

The drug policies of wealthy consuming countries emphasize criminalization, interdiction, and eradication. Such extreme responses to social challenges are inappropriate when the known costs of the responses are high and their benefits uncertain. A wide range of evidence (cross-country to case study) and analytical approaches (from historical to theoretical) shows that this is the case for drug policies. The costs are particularly high for poor transit and producer countries: thousands of deaths in conflicts between drug cartels and security forces; political instability and the infiltration of criminal elements into governments; and rampant narcotics use in countries where consumption was previously negligible.

These policies could nevertheless be worthwhile if their benefits were significantly higher than those of more moderate, less costly alternatives, such as harm reduction. However, benefits remain clouded in uncertainty. Eradication appears to have only transient effects on supply; criminalization may have either very low or very high effects on consumption. Deep uncertainty over benefits, and the high costs of current policies relative to alternatives, justifies greater emphasis on lower-cost policies and more conscientious and better-funded efforts to assess the benefits of all policies.[3]

Liquidity played an important role in the transmission of the crisis

Banks’ reliance on wholesale funding greatly aided the international transmission of the global financial crisis. An event study assesses the impact of the liquidity crunch that followed the demise of Lehman Brothers on the stock price returns of 662 individual banks across 44 countries. It also examines the differences in the abnormal returns observed around those events, and how they relate to banks’ ex ante reliance on wholesale funding.

Globally and within countries, banks that relied more on non-deposit sources of funds experienced a significantly larger decline in stock returns, even after controlling for other mechanisms. Within a country, the abnormal returns of banks with high wholesale dependence fell significantly more than those of banks with low dependence immediately following Lehman Brothers’ bankruptcy. This large differential return underscores the key role of liquidity in the transmission of the crisis.[4]

Economic bonanzas tend to exacerbate credit market imperfections

The crisis has brought credit market failures under the spotlight. One of the key factors behind them is the market’s inability to screen good projects from bad. Under plausible circumstances, favorable real shocks to an economy can aggravate this “lemons” problem, by inducing more entry of high-risk but low-expected productivity projects. This factor can actually lead to the complete collapse of the credit market. The implication is that an economy may see no benefit from a positive real shock—one that potentially increases the productivity of all producers—unless at the same time it makes improvements in governance—that is, in the ability to screen good borrowers from bad.[5]

Macroeconomic risk contributes to bank runs in emerging markets

The conventional view of bank depositors’ behavior in times of turmoil underscores bank-specific characteristics, random factors that trigger runs, or contagion episodes. But evidence from bank runs in Argentina and Uruguay in the 2000s shows that macroeconomic risk is also important. Small macroeconomic shocks can quickly cause large runs. Macroeconomic risk affects deposits quite aside from traditional bank-specific characteristics. Furthermore, bank exposure to macroeconomic factors can explain differences in deposit withdrawals across banks. During crises, the evolution of bank-specific characteristics is mainly driven by macroeconomic factors, while the informational content of bank-specific variables declines. Overall, depositors seem responsive to risk in a broader sense than that often considered by earlier research.[6]

Knowing the size of the government spending multiplier is crucial to the design of fiscal stimulus packages

Fiscal policy has played a central role in many countries’ response to the crises. But there is little solid evidence on the magnitude of its effects, because it is difficult to disentangle the effect of a change in government spending on GDP, from the reverse effect of shocks to GDP on government spending. Sorting this out requires a strategy for finding changes in government spending that are unrelated to current macroeconomic shocks.

A new approach for doing so exploits the long lags between approval and full disbursement of World Bank-financed projects. Because of these lags, nearly all of World Bank-financed government spending in a given country and year reflects project approval decisions made in previous years—and so does not react to current macroeconomic shocks. Using changes in World Bank-financed spending in a sample of 29 aid-dependent low-income countries, the impact of an additional dollar of government spending on output is estimated to be zero. This finding suggests considerable skepticism regarding the effectiveness of short-run spending-based fiscal stimulus packages in such countries.[7]

Raddatz, Claudio. 2010. “When the Rivers Run Dry: Liquidity and the Use of Wholesale Funds in the Transmission of the US Subprime Crisis.” Policy Research Working Paper 5203, World Bank, Washington, DC.